May 18, 2009

One consequence of the financial crisis has been to make investment in mortgage repayment increasingly attractive. Mortgage repayment is a riskless investment that yields a return equal to the interest rate on the repaid loan. If the loan carries a 6.125% rate, the borrower earns that rate on the balance repaid. The yield on other investments of comparable risk, including Federal Government securities, CDs and money market funds, are way down. My money market funds today are yielding barely more than 1%.

Not so obvious but even more compelling, some borrowers in process of refinancing can earn a much higher return on partial loan repayment if the balance reduction allows them to reduce or avoid mortgage insurance coverage. The return is high because the crisis has increased mortgage insurance premiums. Here is an example from my mailbox.

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“My credit is excellent, my income is adequate, my rate is 6.125%, and I
qualify for 5.125%, except for one thing: the value of my house has
declined from 360K to 280K and we owe 242K. My lender says that for us
to refinance we need mortgage insurance, which was not required when we
took out the loan originally. I don’t want to pay for mortgage
insurance…”*

If this borrower can come up with 18K to pay down the balance to 224K, that balance would be 80% of the current appraised value and no mortgage insurance would be needed. Relative to remaining with her current mortgage, the 18K investment would yield 18% over 5 years. The return is not very sensitive to how long the borrower has the mortgage, it will be a little higher if the period is shorter and a little lower if it is longer. The return includes the lower payment over the 5 years plus the smaller loan balance at the end of the period. If the loan runs to term, the return would be 16.6%.

If this borrower does not have the needed 18K, she should refinance anyway and pay the mortgage insurance, because she will be better off. Relative to paying an insurance premium of .62%, investing 18K to avoid it will yield about 13% over 5 years.

Similar logic applies if a partial prepayment converts a jumbo into a conforming loan. Because the crisis has increased the yield spread between them, the return on an investment in prepayment can earn a sizeable return for a refinancing borrower.

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“I have a jumbo mortgage with a balance of $809,000. I can refinance it
at 5% for 15 years, or I can pay down the balance to $729,000 and borrow
that amount for 4.375%. Other costs are about the same. Is this a good
way to invest $80,000?”*

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*

I calculate the yield on the $80,000 investment to be 10.4% over 5 years, and since there is no risk, it is a very good investment indeed. The yield is a little higher if you terminate earlier, a little lower if you terminate later. It is not as high as in the previous case because the investment required to lower the rate is substantially larger than the investment required to eliminate mortgage insurance in the previous case.

If the existing balance is $769,000 instead of $809,000, the investment required to convert the new loan from jumbo to conforming would be reduced to $40,000. In this case, the rate of return over 5 years would rise to 15.4%.

In general, the yield on investment in balance reduction will be above the rate on the mortgage that is paid down by an amount that is larger a) the larger is the rate difference between the jumbo and conforming mortgages, and b) the smaller is the required investment.

Note: I did all these calculations on a hand calculator with financial functions. These are available today for about $20, look for the tell-tale symbols: N, I, PV, PMT and FV. Here is how to calculate the rate of return in the jumbo case.

Calculate the payment and balance after 5 years on the $809,000 jumbo at 5% for 15 years.

Enter: 180 in N

5 in I

-809000 in PV

0 in FV

Solve For PMT = 6397.53

Enter: 60 in N

Solve For FV = 603167 (balance after 5 years)

Repeat the process for the $729,000 conforming loan at 4.375% for 15 years. The payment is 5530.34 and the balance after 5 years is 536734.

Calculate the difference in payment and balance between the two cases. The payment on the conforming loan is 867.19 lower, and the balance is 66433 lower. These are the components of the return on the $80,000 investment in loan repayment.

To calculate that return over 5 years:

Enter 60 in N:

-80000 in PV

867.19 in PMT

66433 in FV

Solve for I = 10.40%

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